China Bonds’ Zero Intolerance

Global fixed income portfolio managers contending with a near $15 trillion universe of low and negative yielding developed world government bonds, with euro-denominated emerging market issues also in the fold, have hailed the entry of positive return Chinese local instruments into benchmark indices. Together inclusion in major Bloomberg, Financial Times and JP Morgan gauges will trigger estimated hundreds of billions of dollars in allocation to raise foreign investor ownership beyond the current 2% share, as compared with an average ten times greater for big developing markets in Asia and elsewhere.  In the region China accounts for three-quarters of the $13 trillion local bond total, as the number two market worldwide in nominal terms behind the US. Starting in February next year, it will get a full 10% individual weighting in JP Morgan’s GBI-EM gauge embedding Asian dominance there, just as in equities where  China’s “A” share addition boosts the already 30% portion on the core Morgan Stanley Capital International Index. This step caps a three-year opening process luring thousands of participants in domestic interbank bond dealing, as Beijing declares a path toward automatic foreign institutional access joining the emerging market mainstream. Its long-awaited arrival on the scene as a top-rated credit is an upbeat asset class story despite growth, trade and banking system concerns continuing into 2020.

Amid the anti-export tariff, currency and national security imbroglio with the US likely to last through next year’s presidential election, an expanded bond channel can support domestic demand through infrastructure projects, and reduce disproportionate bank reliance in total social financing. It will enable China’s global gross domestic product contribution to increase to 20% over time despite a probable shift to current account deficit status, and demographics-driven economic slowdown from decades of the one-child policy. Diversified financial intermediation can offset falling total factor productivity, with recent annual gains in the 1-2% range. However while overseas investors may be sanguine in the near term about the reported government debt level at 50% of GDP, they will insist that the 150% state enterprise load, due to leap another 10 trillion Yuan this year, be reined in for overall sustainability.

On the index launch mechanics, JP Morgan will incorporate a half dozen liquid government bonds, and projects an early $20 billion infusion with the 10% weighting since it is tracked by $200 billion in assets. The Finance Ministry puts the amount outstanding at $2 trillion on a defined yield curve, with 1-10 year maturities auctioned monthly. Banks and insurers are the main buyers with the former taking two-thirds of issuance, and secondary trading is minimal. Policy bank offerings from the Agricultural, Development and Export-Import Banks are also part of the sovereign mix but so far eligible only for Bloomberg’s separate yardstick. With integration Hong Kong’s Bond Connect scheme for onshore entry in effect since 2017 is expected to improve, especially in addressing remittance and settlement complications. The currency convertibility timetable, with a vague next decade target, could also be spelled out concretely to harness fresh inflows, in the wake of recent annual drops in Standard Chartered’s Renimbi Globalization measure. Trade settlement and international payments rankings have declined despite acceptance in the International Monetary Fund’s Special Drawing Right (SDR), and official no-devaluation assurances.

Chinese local corporate bond participation should pick up at the same time despite the absence of a dedicated index, as 80% of borrowing is still through banks and Standard &Poor’s has begun competitive credit ratings. Surveys of central bank reserve managers also reveal an appetite for higher safe asset exposure with only 2% of holdings Yuan-denominated, below the 10% stake in the SDR, amid the search for dollar and euro alternatives on commercial and geopolitical grounds. On an historical view, emerging market analysts predict a similar trajectory for local bonds as external ones the past decade, as half a trillion dollars in corporate issuance now leads as a stalwart in JP Morgan’s benchmark for that field. Offshore investors continue to snap up risky property developer placements this year, with double digit yields rarely available elsewhere. They may default and leave holders at the mercy of uncertain legal recourse, while Chinese central government paper is considered a solid bet for now on the basic balance sheet.   

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